`Reach-through licensing' is licensing of technology/intellectual property, typically patent rights, with royalties based on a percentage of sales, where the licensed technology/intellectual property, such as basic research, is not incorporated into the end product. Despite criticism,[1] reach- through licensing creates a licence the value of which can be measured, and thus solves the problem of valuing basic research per se. Indeed, the value of basic research may not be known at the time of the licence and is usually not known until after production of the end product. Thus, reach-through licensing may be necessary to compensate for use of a basic research invention - either contractually through a licence between the parties, or as a damages award in an infringement action.

The concept of a royalty based on a percentage of sales of a product not per se covered by a patent claim or damages based on sales of an unpatented product is not foreign to US patent law.

For instance, with respect to recombinant technology, in Bio-Technology General Corp. v Genentech, Inc., 80 F.3d 1553 (Fed. Cir. 1996) (`the BTG case'), production of a protein by recombinant means outside the USA and importation of the protein into the USA was held to be an infringement of patent claims to a method for making a vector or microorganism containing DNA encoding the protein, as well as to methods for making the DNA encoding the protein. The Federal Circuit found that it would not have been possible to make the vector (or microorganism), ie the product expressing the protein outside the USA, without using the patented method.

In the BTG case, the Federal Circuit was interpreting the US Patent Statute, 35 USC s271(g), which makes it an act of patent infringement to import into the USA a product of a patented process unless the product is materially changed by subsequent processes. The Federal Circuit relied upon the legislative history of the Process Patent Amendments Act (PPAA) of 1988, Pub. L. No. 100-418, s9006(a), 102 Stat. 1107, 1567 (1988), namely, Senate Report, S. Rep. No. 83, 100th Cong., 1st Sess. 51 (1987). In that Report, the Senate contemplated the effect of the PPAA on a patented process of preparing a DNA molecule comprising a specific genetic sequence. The Senate considered that a foreign manufacturer could insert the DNA into a plasmid or other vector and obtain expression of the polypeptide encoded by the specific genetic sequence. The Report stated that `if it would not have been possible or commercially viable to make the ... product expressed ... but for the patented process, the [polypeptide] product will be considered to have been made by the patented process.'

While the BTG case turned on a question of statutory interpretation (what does `materially changed' mean?), it may signal that the Federal Circuit would be receptive to arguments that damages for infringing a patent directed to basic research may be measured by royalties on the sale of an end product from the use of that basic research.

Indeed, in Rite-Hite Corp. v Kelley Co., Inc., 56 F.3d 1538 (Fed. Cir. 1995), the Federal Circuit affirmed an award of damages based on lost sales of an unpatented product (a vehicle restraint). The Rite-Hite Court based its decision on the `entire market value rule'. This rule permits recovery of damages for the value of a whole product, though just a portion of the product is patented, if the patented portion is the basis for customer demand for the whole product. The Rite- Hite Court, however, stated that there was `no basis for extending that recovery to include damages for items that are neither competitive with nor function with the patented invention'.

Nonetheless, 35 USC s284 authorises an award of `damages adequate to compensate for the infringement, but in no event less than a reasonable royalty for the use made of the invention by the infringer.' Damages may be based on lost profits; for instance, lost profits arising from potential sales that were lost to actual sales made by the infringer; lost profits arising from price cuts made because of the infringer's competition; and lost profits arising from projected lost sales. See Lam, Inc. v Johns-Manville Corp., 718 F.2d 1056 (Fed. Cir. 1983). On the other hand, an invention directed to a basic research tool may not fit within the `lost profits' model for damages owing to the limited use of or market for a basic research tool. The basic research tool may be the key necessary to unlock the door to a major end product.

Thus, damages for infringement of a patent claim to a basic research tool may fall under the `reasonable royalty' standard that is applicable if the patent owner cannot establish a loss of profits. [2] Under the `reasonable royalty' standard, damages for infringement are calculated based on an established royalty in the industry, or, in the absence of an established royalty, by calculating a royalty using the `willing licensor-willing licensee' rule: a royalty payment that would result from a hypothetical arm's-length negotiation between a patentee willing to grant a licence and a potential licensee willing to pay for it. [3] But are the damages for infringement of patent claim to a basic research tool, or a reach-through royalty licence, justified? Is appropriate to base the value of a research tool on the performance of an end product? To a large extent the value of the research tool should be based on the end product for the simple reason that the technology enables the development of the end product, eg the drug product. In some cases the research tool may be essential in developing a blockbuster drug; for instance, a drug that enjoys US$1bn in sales per year. From cases such as BTG, one can argue that, but for the patented tool, there may never be a blockbuster drug at all. [4]

Avoiding a Court award of a reasonable royalty - trebled for wilful infringement - plus attorney fees (for both the drug developer and the patentee in litigating the matter) and a permanent injunction against making, using, selling or offering for sale the US$1bn per year drug, [5] ie the certainty of being able to proceed with development of the drug beyond the enabling technology, easily could be worth a reach-through royalty as low as 0.25-0.50 per cent (US$2.5-5m a year) or even as high 1-3 per cent (US$10-30m) on a US$1bn per year drug. Thus, a reach-through royalty licence arrangement can be justified.

In Ligand Pharmaceuticals, Inc. v Pfizer, Inc. (Superior Court California, San Diego County, 1994), litigation involving contract issues and not patent infringement, Ligand commenced the action against Pfizer for milestone payments and royalties related to their osteoporosis-screening project. [6]Ligand and Pfizer had entered into a five- year collaboration wherein Pfizer funded research and drug discovery using Ligand's intracellular receptor technology for the treatment of diseases. [7]Under the agreement, Pfizer received exclusive worldwide rights to market any products resulting from the collaboration, with Ligand to receive royalties on the sales. As part of the settlement of the lawsuit, Pfizer gave Ligand in excess of US$1.3m and agreed to make additional payments as Pfizer developed future compounds, with the expectation that drug products would be marketed. [8] Thus, parties are entering into reach-through licensing arrangements, and the cost of basic research technology - a reach through royalty licence - may be not be that significant when compared with the return from the end product drug. Also, a reach-through royalty may not be that significant in view of the fact that but for the research tool, there would not have been the end product drug.

Consider further that if the basic technology enables the development of a drug, it is likely the drug developer will surround the drug with other patents that will probably have a longer life than the patent on the enabling technology, such as patents on the active compound of the drug and method of use patents. The patent term is 20 years from filing. It usually takes about three years for a patent to issue and approximately five to seven years (or longer) for a drug to be developed and brought to market. It will be in those five to seven years that the drug developer will file for the surrounding patents. Thus, the reach-through royalty may begin in the tenth year of the patent on the enabling technology, ie the reach-through royalty may be for only about the latter 10 years of the patent on the enabling technology. However, owing to the surrounding patents and market forces, the market for the drug can last longer than the term of the patent on the enabling technology. That means that the drug developer might realise a US$1bn per year market for 15 years or US$15bn, because of the enabling technology, and have an outlay of reach-through royalties of only US$25-50m (at 0.25 or 0.50 per cent royalty for only ten years) or US$100-300m (at 1-3 per cent royalty) - a token amount considering that without the enabling technology there would have been no drug and no US$15bn, and that in the latter years of market exclusivity there is likely no reach-through royalty. Even if it cost the developer of the drug US$500m in additional costs to bring the drug to market, those costs plus the reach-through royalty still appear to be minor amounts in comparison to US$15bn.

If the basic research tool - the enabling technology - cost at most only US$2m to develop and patent (or less), a reach- through royalty of US$25-300m still may not be excessive compensation. The value of a patented research tool is not simply the costs that went into developing and patenting the technology. Rather, the value of the patented research tool is those costs plus the value of the access to the technology, ie that the technology enables another to make further developments, such as the blockbuster US$15bn drug; and, the value of access to the patented research tool - a reach-through royalty licence - can further include the certainty to the drug developer to proceed with developing the drug product (eg avoiding: litigation, reasonable royalty damage assessment, trebling thereof for wilfulness, attorney fees and permanent injunction). Simply, it is the market-place - not the cost of patenting and developing the technology - that determines the value of the invention.

Indeed, consider that there can also be a `paper patent' and `paper technology' - a patent that has been granted on technology that the inventor has dumped money into developing and prosecuting to issuance, only to find that there is no market for a product covered by the patent or for any commercial use of the technology; for instance, a research tool that no one cares to use to develop any end product drug. Sums were spent on developing and patenting the technology of such `paper patents' or `paper technologies'; but their value may be zero as there is no product or commercial use for the technology.

Consider further that in reach-through licensing the value of the enabling technology is based on the end product. If there is never any end product, there is no reach-through royalty. Similarly, if the end product does not enjoy an enormous market, the reach-through royalty may not amount to sums as great as US$25-300m.

The licensor is taking a gamble, albeit with less risk than the drug developer, that the research tool will indeed enable the development of the blockbuster drug and not be a tool that leads to dead-end research or a low-yielding product. For instance, the licensor may agree to a minimum payment of US$10,000 per year plus 1 per cent royalty on net sales of end product, with the royalty rate reduced by 50 per cent if the drug developer must pay total royalties of 3 per cent or more on net sales of end product, with termination options after five years (eg by the licensor if certain milestones are not met and by the licensee at will after five years). If the research tool yields no product, ie the milestones are not met or the research tool is not that good, the licensor may only realise US$50,000.

Thus, the measure of value of a basic research tool is not merely the costs for developing and patenting the basic research tool; but rather the extent to which the basic research tool enables the development of further products and the value of those products; namely, market-place forces.

A drug developer typically assumes any liability regarding the end product. It may appear inequitable that the developer of the basic research tool will receive a percentage of sales, despite not participating in marketing, manufacturing or distribution, or the assumption of liability. However, the developer of the basic research tool developed the research tool and it solved problems the drug developer either could not afford or did not find profitable to solve, or did not timely solve first; and the research tool - the enabling technology - played a pivotal role in developing the end product. Simply, without the basic research tool, the end product would not have been produced.

Consider certain infringement scenarios, wherein to develop a drug, the drug developer can either infringe a basic research tool patent in a five year programme, or proceed with another, more costly, longer research programme; and, the drug developer elects the less expensive, infringing route. In one scenario, the drug developer proceeds with infringement and it leads nowhere, ie no drug is produced, and nothing is ever published concerning the infringing research. The infringement was like running a red light at 3:00 am when there is no policeman or anyone else out on the street; a reach-through royalty awarded on this research is probably zero, and a reasonable royalty on this infringement may be the sum one would pay as an annual licensing fee for the term of the research project, eg US$50,000. Alternatively, in a second scenario, the infringement by the drug developer results in a blockbuster drug that has sales of US$1bn per year. Is it fair to award the patentee only US$50,000 when but for the infringement the drug developer would not have realised such sales or such sales so quickly, and if the research tool was no good (as in the first scenario) there would not have been such sales or such sales so quickly? The value of the patented research tool is thus reflected in the value of the end product.

Therefore, a reach-through royalty may not necessarily be inequitable or excessive compensation, despite the fact that at first sight it may seem shocking to possibly receive US$25-300m for an investment in research and patenting that may have been only several hundred thousand to a few million dollars. But, such returns are contingent on the end product being a blockbuster and show why patents are within the term `intellectual property'.

Accordingly, a reach-through licence that is in place may be used as the measure of damages in an infringement action based on a patent to a basic research tool. The patentee should be able to seek royalties on an unpatented end product resulting from the infringement of the basic research tool patent, based on the `reasonable royalty' standard and any existing reach-through licence.

Moreover, even in the absence of an existing reach-through licence, a patentee should be able to seek as damages in an infringement action royalties based on an unpatented end product on the theory that the award of damages for infringement should be adequate to compensate for the infringement and no less than a reasonable royalty, and that under the `willing licensor-willing licensee' rule the royalty would have been a reach through royalty.

Indeed, in Engel Industries, Inc. v Lockformer Co., 96 F.3d 1398 (Fed. Cir. 1966), the Federal Circuit held that royalties may be based on unpatented components (corners of duct work), if it is a convenient way for measuring the value of the licence. Thus, it is possible that reach-through licensing can be a measure for damages in an infringement action.

However, in Engel, the Court applied the antitrust `Rule of Reason' standard in accordance with Zenith Radio Corp. v Hazeltine Research, Inc., 395 US 100 (1969), an old case that involved patent pooling in the electronics industry. The rule of reason standard holds that a restraint of trade that does not violate the Sherman Act per se, will violate the Act only if it imposes an unreasonable restraint on competition. In Zenith, the Supreme Court applied the antitrust Rule of Reason standard in holding that there was patent misuse because the patentee compelled the licensee to pay royalties on products not made or sold under any of the licensed patents.

The Zenith Court stated that `misuse inheres in a patentee's insistence on a percentage-of-sales royalty, regardless of use, and his rejection of licensee proposals to pay only for actual use.' The Zenith Court continued that while `a licensee must pay if he uses the patent . . .he may insist upon paying only for use, and not on the basis of total sales' because `[t]here is nothing in the right granted the patentee . . .which empowers him to insist on payment not only for use but also for producing products which do not employ his discoveries at all' (emphasis added).

But possible antitrust and patent misuse issues - possible liability for treble damages or possible patent unenforceability until the offending practice is terminated - should not prevent `reach-though licensing'. The Zenith Court's statements must be considered in the modern light of the rationale of the Engel Court, and the fact that reach-through licensing can be the only real way (1) for the parties to value basic technology and (2) for the courts to comply with the congressional mandate to award adequate compensation for infringement of basic-research patents.

The antitrust laws seek to prevent holders of market power, eg those who have the power to control price or competition, from harming competition through unreasonable conduct, whereas patent misuse focuses on whether the patent owner has impermissibly broadened the scope of a patent with an anti-competitive effect. [9]

Under the antitrust Rule of Reason, pro- competitive effects are weighed against anti- competitive effects, and the question posed is whether the restraint on competition (eg paying royalties on unpatented product) is necessary to achieve benefits that outweigh the anti-competitive effects.

Section 271(d) of 35 USC provides that it is not patent misuse or an illegal extension of a patent right to derive revenue from acts that, without consent, would be contributory infringement (selling goods for use in a patented method), licensing another to perform acts that without consent would be contributory infringement (licensing another to sell goods for use in a patented method), enforcement of a patent, refusal to licence or use a patent, or conditioning a licence on the acquisition of a licence to another patent or the purchase of a separate product, unless the patent owner has market power in the relevant market.

Thus, a patent is not presumed to give the owner market power.

While in the 23rd December, 1999 Federal Register Notice, the National Institutes of Health (NIH) maintains that `imposing reach-through royalty terms as a condition of use of a research tool is inconsistent with this principle [of ensuring appropriate distribution of NIH-funded tools]', the NIH also recognises that `[w]hen transferring an NIH-funded research tool to a for-profit entity that intends to use the tool for its own internal purposes, recipients are entitled to capture the value of their invention.'

Similarly, in the 23rd December, 1999, Federal Register Notice, the NIH encourages `[a]rrangements such as execution or annual fees', asserting that `[r]oyalties on the sale of a final product that does not embody the tool, or other reach-through rights directed to a final product that does not embody the tool, discourage use of tools' and that `[r]oyalties on the sale of final products are more appropriate to situations where a for- profit entity seeks to commercialize the tool, e.g., by developing a marketable product or service, or incorporating the tool into a marketable product or service.'

However, the `[i]n the final policy, the NIH has left considerable discretion to Recipients in determining how to achieve the principle of ensuring appropriate distribution of NIH-funded tools' and while reach-through royalty arrangements are discouraged, it cannot be said that there is a per se rule against them. The NIH suggests that `Recipients should engage in such interactions on an infrequent, case-by-case, and highly controlled and monitored basis.'

Thus, while the NIH may have an issue with reach-through royalty arrangements in view of the NIH's principle of ensuring appropriate distribution of NIH-funded tools, the pronouncements of the NIH have not been contrary to indications that reach through licensing can be consistent with US patent and antitrust laws.

Further, while the NIH may have its view, it is respectfully submitted that this author has observed that larger, for-profit companies have offered miniscule lump sum execution fees that would barely cover the patent prosecution costs for patent protection for basic research, only to agree eventually to proper annual payments and royalties based on a percentage of sales of end product - reach-through licensing - illustrating that reach-through licensing is indeed a necessary reality to `capture the value of ... invention'.

This phenomenon may very well be the result of the NIH's indictments of reach- through licences. Industry - for-profit companies - may, in licensing negotiations, initially offer miniscule lump sum payments, expecting institutions not to insist upon reach-through licensing in view of the NIH's pronouncements against it. Perhaps, too, the NIH's pronouncements may cause institutions to forego applying for and receiving NIH funds so as to preserve the possibility of engaging in reach-through licensing. Institutions may turn to for-profit companies to fund basic research, with the funding being considered as pre-payment of royalties on end product in a variation on reach-through licensing. Of course, some institutions may simply continue to receive funding from the NIH and continue to engage in reach-through licensing, without concern that some or all of the basic research was funded by an NIH critical of such licensing. How institutions change their licensing practices in view of the 23rd December, 1999, Federal Register Notice is yet to be seen.

In line with Court cases such as Engel, the Department of Justice (the governmental body charged with enforcement of the antitrust laws) and the Courts currently view licensing provisions as potentially pro- competitive. [10]Intellectual property is neither free from scrutiny nor particularly suspect, and the Department of Justice will not challenge a licence that is not facially anti-competitive, or where the licensor and licensee collectively account for no more than 20 per cent of each relevant market. [11]

The areas of concern for the Department of Justice are licence restrictions on goods or technologies other than the licensed technology, licence provisions that deter licensees from dealing with suppliers or products that compete with the licensor, and acquisitions of technology that lessen competition in a relevant market.

Accordingly, reach-through licensing provisions in biotechnology licences can be upheld as within the antitrust and patent laws and need not raise concern with the Department of Justice, if done for the convenience of the parties (eg if it is a convenient way to value the technology), and if other provisions of the licence - such as grant backs, multiple patents being licensed and field-of-use restrictions - do not present problems.

For example, the licensor may want a grant back provision to take back the technology if it is not used, or to prevent `improvements' from significantly diminishing the licensor's market. Non- exclusive grant back of improvements and/ or a grant back that is no broader than the original licensed subject matter may avoid patent misuse and antitrust issues. [12]

When licensing patents with different expiration dates, such as when platform technology is licensed with improvements, the licensor should take care to avoid possible antitrust and patent misuse issues. The licensor can offer a variable royalty rate on the combination of licensed patents which decreases as the patents expire, or a choice between either a constant royalty rate until the expiration of the last patent, or individual licences under each patent in the combination of licensed patents - like a restaurant offering a choice of prix fixe or aÁ la carte meals. The total fee for the individual licences under each patent can cost more initially than the constant rate to compensate for the accounting issues raised by the individual licenses.

The antitrust/patent misuse issue arises in licences involving more than one patent when royalties are collected after patent expiration. [13] The issue is addressed by providing the licensee with the option to accept individual licences or the constant royalty rate until the expiration of the last patent. In regard to the constant royalty rate arrangement, while this option may appear to collect some royalty on an expired patent at the latter end of the licence, the constant royalty rate may be viewed as merely spreading the earlier higher payments of the individual licences out to the latter end of the licence term: an economic benefit to the licensee.

Field-of-use limitations can be useful where the licensor wishes to license the basic research and associated intellectual property to one party for a particular product, and to a second party for a different product. Field-of-use/territory limitations - including single use restrictions - have generally been upheld under the Rule of Reason standard. 14

Thus, reach-through licensing and ancillary licence provisions can be employed within the patent and antitrust laws; and reach-through licensing and royalties may become a measure of damages in an infringement action.

Typical royalties in reach-through licences can be between 0.5 and 3.0 per cent. However, flexibility may be the key in structuring the royalties. An end product that is subject to many royalty payments to different parties may cause the product to be prohibitive to produce or sell; it may cost the manufacturer too much to introduce the product to the market or to sell it. The licensor may wish to consider that maintaining a firm 0.5 or 1.0 per cent royalty on an end product may cause the manufacturer to forego producing or selling or introducing the product, especially if the manufacturer must pay such amounts to other licensors. The licensor, who is keenly aware that some royalty on an end product is better than no royalty where there is no end product, should consider that perhaps the royalty may be reduced or vary over the life of the licence.

For instance, the licensor may consider that the royalty be reduced by a percentage, such as 50 per cent, if the manufacturer- licensee must pay a royalty amount, such as 3.0 per cent or more royalty, on the end product to the licensor and other licensors and/or a sliding scale royalty rate, ie a royalty rate that increases over the life of the patent or the license such that the royalty rate is lower when the product is initially introduced and higher later in the license, after the product has attained a market.

In sum, not only can reach-through licensing be employed without running afoul of the patent and antitrust laws, but reach-through licensing can be used in a manner that does not create prohibitive costs for getting technology or products to market. While to the knowledge of the authors, the case has not yet been litigated where reach-through licensing and royalties have been a measure of damages for infringement of a patent directed to a basic research tool, it seems that reach-through licensing and royalties can indeed be a measure of damages for infringement of a patent directed to a basic research tool.